Volatility Index Hits Three-Month High

By Brendan Conway

Volatility, rising? Yes, for once. The close of trading in Europe happened with a thud, and U.S. markets are just off session lows around lunchtime.

The CBOE Volatility Index is ahead by 22% on the session as of mid-Thursday. The index three-month high today still only brings it to the 16 level, which is below the historical average (20).

MKM Partners‘ derivatives strategist Jim Strugger asks clients this afternoon: “Is This the One?” By which he means, is this the selloff investors have been fearing? His suggestion is yes, but perhaps not an especially big one. In Strugger’s view, investors should get ready for something resembling the modest selloffs of the last 20 months.

Volatility-trading vehicles are flying off the shelves, not that they’re easy to catch when they do that. VelocityShares Daily 2x VIX Short-Term ETN (TVIX), ProShares Ultra VIX Short- Term Futures (UVXY) and Barclays iPath S&P 500 VIX Short-Term Futures ETN (VXX) are gaining by anywhere from 7% to 15%.

If you’re a bull, it’s a buying opportunity. If you’re less certain, one way to protect yourself — not that fund marketers will remind you — is simply to hold more cash.

After a review of the various selloff-protection ETF strategies on the market, this is what the Barron’s ETF Focus column recommended a few weeks back. Here it is again in full:

Worried about a stock-market selloff, and feeling unprepared? You’re not alone. The CBOE Volatility Index soared 32% amid Thursday’s geopolitical tensions. Fears rose over Russia and Ukraine; nerves were rattled by Israel and Gaza. Grim as it may sound, there are exchange-traded funds created to capitalize on all this — in fact, dozens. The troubles with these selloff-protection strategies are several: substantial tradeoffs, short track records, and complexity.

The first breed of selloff-protection ETFs tends to surge with sudden market stress. Some volatility ETFs, for instance, surged nearly 20% on Thursday. If that sounds promising, it’s not. Even for short-term hedgers, success is elusive. The steep and unpredictable costs of buying and selling volatility futures can be anywhere from 40% to 70% a year — buy-and-hold investors will, on average, lose this much just by owning it.

Take the impossibly named iPath S&P 500 VIX Short-Term Futures exchange-traded note (ticker: VXX). Though it rose 10% on Thursday, the ETN has dropped more than 99% since its launch in 2009, reflecting the high cost of using these as insurance. “Sellers can charge whatever they want for tomorrow’s volatility,” says Dave Nadig, chief investment officer of industry research firm ETF.com. “So your timing has to be perfect,” since you don’t want to hold these ETFs for longer than a few days.

The next group tries to be the Muhammad Ali of ETFs: Float like a butterfly (when stocks rise), sting like a bee (with that stinger aimed at plunging stocks, and not you). The $623 million Barclays S&P 500 Dynamic Veqtor ETN (VQT), for instance, uses a complex formula to shift money between stocks, cash, and volatility futures. It shone brightly in a rough 2011. The trouble here is trusting the engineering. Buyers sign on to a complex index in a product conceived after the financial crisis. That’s a bigger problem than it first appears. Fund makers have strong incentives to sell you yesteryear’s winners; investors’ natural instinct is to hew to just those strategies. But that may not work out, argues Morningstar strategist Samuel Lee. Paradoxically, the very act of sifting through historical data for the perfect hedge increases the chance you’ve simply found a red herring, with no guarantee it’ll work next time. “You have no way of telling how much this index was tweaked before launch,” Lee says. “We’re only talking about this because it worked before.”

A third way is to give up the bobbing and weaving and go for slow and steady. Here, “alternative” ETFs, such as IQ Hedge Multi-Strategy Tracker ETF (QAI), have had some success. This fund, which replicates various hedge-fund strategies by buying and selling other ETFs, rather than individual securities, was up 2.8% for the year as of Thursday, and fell by just half a percentage point as tensions flared. It often does better than that in a selloff. With a five-year annualized return of about 4% and no steep drawdowns, you begin to see why investors have forked over $786 million.

There’s no free lunch in investing. For that reason, cash may be just the thing for worrywarts who can’t stomach a short-term loss — not that you’d ever hear it from an ETF executive.

About Focus on Funds

As exchange-traded funds and other investing vehicles have ballooned in number, the task of figuring out what works well and what doesn’t has only gotten harder. Barrons.com’s Focus on Funds looks under the hood of ETFs, mutual funds and hedge funds for overlooked values, actionable ideas and the latest pitfalls for fund investors.

Chris Dieterich has covered the U.S. stock market for The Wall Street Journal and Dow Jones Newswires. He is a graduate of Regis University and the Missouri School of Journalism.